Tax Exempt Fixed Income Strategy

Municipal bond yields moved modestly higher through the first half of 2004, reflecting both sound economic growth and the concern that inflation may return. The following chart shows that despite higher absolute yields in the longer maturity areas, rate levels in the short and intermediate areas had a greater basis point increase from year-end.

These comparisons help to point out the effect of yield movement on price changes. Bond prices are susceptible to change with interest rate fluctuations, with prices moving in the opposite direction of the move in interest rates. Typically, those bonds with longer duration experience more fluctuation. As a result, investors with longer duration investment structures lost more market value during this period of rising rates than did investors with shorter duration investment structures, even though the yield is higher and the year-to-date rate of change is less. This cause-and-effect partially explains the ability of shorter duration Oakwood client portfolios to withstand the upward move in interest rates. Our more cautious investment stance, i.e. shorter duration, provided good market protection during this difficult period of rising interest rates. For more than a year, we have allowed our overall maturity structure to shorten with the passage of time and restricted our purchase of longer securities. By avoiding the tendency to “chase yield”, price sensitivity was reduced. Expressed another way, longer maturity municipals may seem more attractive on a yield basis, but shorter maturity municipals are more defensive when interest rates rise.

We believe the current shift in Fed policy should be viewed as a positive sign to the markets. An effective Fed policy is designed to maintain an orderly economic recovery and the Fed stands ready to raise rates in order to assure stability. Federal Reserve Chairman Alan Greenspan, over his 17-year tenure, has repeatedly stated that controlling inflation is the best way to guarantee economic success. Knowing this first increase in over 4 years is unlikely to be the last, we remain prepared to reenter the longer maturity area on a limited basis. We will start by extending certain shorter holdings into call-protected 10 to 15 year investments. Our initial target for this maturity range is 10%.

One measure in determining the attractiveness of municipal bonds is the yield ratio of tax-free investments versus taxable Treasury securities. Currently, 10-year municipals are yielding approximately 90% of their counterpart Treasury yield, well above the historic norm of approximately 82%. In addition, several developments within California may be beneficial to all clients. After months of underperformance relative to other states, California is beginning to compete again. Led by the new governor, this change started with California’s proactive approach in solving its budget crisis. Proposition 57, which allows for up to $15 billion in “Economic Recovery” bonds, received overwhelming support by voters. Although this solves the near-term liquidity crisis, the state will be running a $7 billion budget gap for some time. Nonetheless, this first step was greeted by a ratings increase from Baa1 to A3 from Moody’s. This event, combined with relatively high yields, makes municipalities within California attractive to both resident and non-resident clients. However, we will continue to avoid California-specific bonds until state deficits are reduced.

On balance, we continue to view tax-free bonds as an excellent investment choice for clients seeking risk reduction, investment diversification and a tax shelter. We have maintained market value during this rocky period, providing a sound basis for future growth as stability returns to the market place.